The independent broker-dealer industry is at an important crossroad. How advisors work and how b-ds survive and serve their clients have been in some cases on a collision course. Understanding this conflict is important to independent advisors who want to choose a broker-dealer that truly suits their needs and where they will feel comfortable and confident. While it's true that only some 10% of advisors are looking to change their firms in any given year, this discussion is not only relevant to them. It can be argued that every year advisors "renegotiate" their contract with their firm when they chose to stay.

Often advisors don't know how to fully evaluate a broker-dealer and so they focus in on payout as the overriding factor. But as payouts continue to rise and profit margins for b-ds continue to shrink, advisors have to realize that some b-ds may be making their profits in ways that conflict with the interests of advisors and their clients.

Advisors probably know much of this already but choose to consider the economic challenges of the broker-dealers as "not my problem." Maybe it is their problem, though, because the economics often define the relationship. Knowing how a broker-dealer makes money can help advisors understand the trade-off between the payout they receive and the potential conflicts of interest they are willing to live with.

Disappearing "Rep" 

The conflict all has to do with the shifting role of the advisor. Traditionally broker-dealers were created to supply financial products to registered representatives, who then sold them to consumers. The profits from the products were the center of the economic relationship and the role of the broker-dealer was to maximize the throughput. The distribution piece of the equation didn't have to do much more than break even.

Today, however, the center of the relationship has shifted from the product to the skills of the advisor. It's rare for advisors to describe themselves as registered representatives of a broker-dealer anymore. Indeed the term "rep" is quickly disappearing from the vocabulary of even broker-dealer executives themselves. This shift in terminology is indicative of the fundamental shift in the role of affiliated advisors. Today's advisors are in the catbird seat: they control the relationship with the client and their advice is not so easily replaced. As a result, they have gained substantial bargaining power with broker-dealers. In addition, advisors have become a limited resource: There aren't enough of them to meet the rising consumer demand, so b-ds are having to compete ever more vigorously to recruit them. Consequently, payout ratios are steadily rising with no end in sight.

This puts broker-dealers in dicey position. Even in good times, their profit margins were never spectacular, and the profitability picture has been far from stellar for the past several years. The independent broker-dealer industry saw losses of 1% to 0.5% from 2001 to 2003, followed by a slight improvement in 2004 and 2005 when the average broker-dealer profits reached 1.5% industry-wide. But that profit has eroded recently, according to Moss Adams's 2007 FSI Financial Performance Survey. It's been hard to manage the bottom line with very competitive payouts. At the same time service expectations have increased and with them the cost of being a broker-dealer. Based on Moss Adams data, the number of compliance employees per dollar of business has doubled. The number of staff in marketing and practice management has also doubled, and technology expenses as percent of revenue have increased too. Considering these increases in cost and an environment where payouts over 90% are frequently advertised, it may appear that a broker-dealer has to provide all of these services for less than 10% of the revenue.

In reality, broker-dealer expenses are typically higher than 10%, but also the effective payout is not 90%. The fact is that not all advisors qualify for the 90%-plus payout. In fact, as a percent of commissionable revenue, broker-dealers pay out about 82% of the total revenue, for an 18% gross margin, which is largely eaten up by roughly equivalent operating expenses (approximately 12% in operating expenses and 6% in other direct expenses such as clearing and other costs). It would clearly be difficult for most broker-dealers therefore to pay out 90%+ to their advisors. But b-ds don't generally have to make such rich payouts primarily because the average advisor generates $126,000 in gross dealer concession (broker-dealer revenue). Very few broker-dealers have average revenue per advisor of $250,000 or more.